Wednesday, September 8, 2010

New Blogs For 2nd Year

Hello anyone who reads these things!

Just thought I'd let you know, I'm starting some new subject blogs for the impending school year. I'm going to be making one for
-PSYC 207 (Contemporary Topics in Darwinian Approaches to Mental Health and Psychological Disorders with Dr. Wehr)
-PSYC 314 (Health Psychology with Dr. Perrino)
-PSYC 217 (Research Methods with Dr. Brenner)

If you're taking any of these classes, I encourage you to check out my subject blogs, as they may be a useful resource for studying and learning the material (it's always good to consider the same information from someone else's perspective). If you followed along with me for Econ or Sociology (two subjects which I enjoyed, but no longer have room for), I would definitely encourage you to start up your own subject blogs, either as an individual, or as a collective. I found these, personally, to be a great learning tool, as well as a great way to take on some academic leadership...

Feeling inspired?

Other than that, I just wanted to wish everyone best-of-luck for the fall session. Have an awesome year, everyone!

Tuesday, April 20, 2010

Exchange Rates and the BOP


Okay- final bit, and then we can all write our exams and promptly forget everything we ever needed to know about economics! =D

What is a balance of payments? It's a summary account of all the receipts and payments in and out of Canada (or any other country) in relation to the rest of the world (including payments made for both goods and investments). It clocks Canadian money moving back and forth across the border. Receipts are money going into Canada, and payments are money going out of Canada.

The balance of payments includes both current and capital accounts. Because these two accounts always balance out, the balance of payments will always be 0. You'll see why in a little bit.


-There is more money going in than out
-This is favorable
-We also call this "credit"
-More receipts than payments

-There is more money leaving than entering the country
-This is unfavorable
-We also call this a debit
-More payments than receipts

When foreign consumers buy Canadian exports, this creates a receipt (money enters Canada from the outside)
When domestic consumers buy foreign imports, this creates a payment (money leaves Canada)

-These are holdings held by the BoC
-It includes gold, foreign exchange, and SDRs
-SDRs are special drawing rights, and they are the IMFs substitute for gold



Basically, a bunch of different sub-accounts which measure trade flows

1: The Current Account (The BOP for goods)
-This encompasses exports, imports, and investment incomes
-The Trade Account is a subcategory of the current account, and it includes an account for merchandise, and an account for services. This account stacks up exports and imports and measures the difference difference
-The Capital Service Account measures the net investment income and unilateral money transfers. This measures the difference between Canadian interest and dividends on foreign bonds and investments, and Foreign interest and dividents on Canadian bonds and investments

2: The Capital Account
-This encompasses money spend on long and short term capital investments, including stocks, bonds, realty, factories and other investment devices
-Financial capital imports are A CREDIT (this may be confusing)! This is when foreigners bring money into Canada in order to purchase Canadian assets. Subsequently, financial capital exports are capital outflows: when Canadians bring money out of Canada in order to purchase foreign assets.
-Finally, the Capital account also includes the official financial account, which measures receipts and payments of Canadian dollars due to the selling and buying of foreign exchange. Selling foreign exchange constitutes a receipt of Canadian dollars, and thus counts as a receipt on the balance of payments. Essentially, the official financial account balances out the other two accounts: when Canadians buy a whole lot of foreign goods and investments, for instance, the BoC accommodates this by selling off foreign exchange for Canadian dollars (which thus counteracts the account deficit caused by other categories)
-An increase in official receipts means that the Bank of Canada is selling Canadian dollars in order to buy foreign exchange. This creates a negative balance effect (it counts as a debit on the balance sheet)
-An decrease in official receipts means that the BoC is selling foreign exchange in order to buy Canadian dollars. This creates a positive balance effect (it counts as a credit on the balance sheet)


Current accounts = X - M + Returns to Investments
Capital Accounts = Capital in - Capital out, + Official Financing Account (which is Can$ in - Can$ out)

As you can see, the OFA always balances out all other payments and receipts, so the Balance of Payments is always 0! Sometimes, news media will talk about exchange deficits or credits, and when they are doing this, they are usually omitting the OFA.

So... if there are more exports than imports, foreigners are short of Canadian dollars, so the BoC will sell Canadian currency to foreigners (and in doing so, increase its holdings of foreign currency). This counts as a negative entry in the OFA: in this way, the BoC provides the excess Canadian money that foreigners require to buy Canadian exports.


-The BOP always balances
-BOP balances or deficits are balanced out by the OFA
-There is nothing inherently good or bad about balances. A deficit is not necessarily bad, and a surplus is not necessarily good!



Okay- foreign exchange can be seen as a marketable good, just like anything else. As such, we have the FOREIGN EXCHANGE MARKET

External Value is how much domestic currency is worth in foreign terms (the foreign price of domestic currency)

Exchange Rate is how much foreign currency is worth in domestic terms (the domestic price of foreign currency)

ER = 1/EV & EV = 1/ER

Depreciation means that the external value is going down
Appreciation means that the external value is going up

What determines external value (and by association, exchange rates)???


Remember: People supply currency in order to purchase imports or to facilitate capital exports (domestic investiture into foreign markets) and people demand currency in order to purchase domestic exports, or to facilitate capital imports (foreign investiture into domestic markets)...

Basically, supply of any currency increases as that currency becomes valued more (because high valued currencies can buy more imports, and translate into larger foreign investments), while demand for any currency shrinks as that currency appreciates (because this makes exports from that country more expensive, and capital in-flows less effective)

As such, currency prices tend to settle at an equilibrium value!

Remember, however, that demand and supply can shift here to affect the equilibrium price level!
Supply of currency will increase if
-There is heightened demand for imports
-There is heightened domestic demand for investment in foreign markets
-Domestic prices are higher than foreign prices

Demand for currency will increase if
-There is a heightened demand for exports
-There is a heightened foreign demand for investment in domestic markets
-Foreign prices are higher than domestic prices


Surpluses, Deficits, and the EV

For surpluses, exports are higher, imports are low, demand for domestic currency is high, supply of it is low, and thus the currency appreciations

For deficits, exports are lower, imports are high, demand for domestic currency is low, supply of it is high, and this the currency depreciates

You can verify this by moving the supply and demand curves around!


PRICES AND EXCHANGE RATES: Exchange rates facilitate the rule of one world price!

Domestic Prices = the exchange rate * Foreign Prices

And this translates into a stabilization mechanism- I'll show you!

When external value is higher, domestic prices become cheaper for international goods (due to the above formula), and as such, exports decrease, imports increase, and we are left with a BOT deficit (which brings the EV back down again)

The reverse is true for when the domestic value is lowered.

As such, the balance of trades and the exchange rate are interdependent and cyclical!



Sunday, April 18, 2010

Trade Policy

This chapter looks at the policies which either facilitate or impede free trade in the world!

As economists, we usually are in favor of free trade. We recognize that free trade offers many benefits to different countries!

Why is free trade a good idea?
-The law of comparative advantage
-When there is regional specialization and trade, the world production of all products rises
-This maximizes the world's average standard of living (world GDP per capita)

On the other hand, some countries may attempt to instill protectionist policies (policies which counteract free trade in order to protect domestic firms from international competition). These can include both TARIFFS and NON TARIFF BARRIERS (NTBs, such as quotas, customs procedures, anti-dumping duties and countervailing duties).

Why might nation choose certain degrees of protectionism?


1: To improve the terms of trade! If a country is large enough, it can force the world price downward for goods it imports by imposing a Tariff

2: Infant Industry Protection. Some countries may set up trade barriers in order to protect domestic firms from international competition, with the hopes that these industries will grow to the point where they can realize economies of scale. The idea here is that under protection, infant industries will eventually "grow up" to the point where they will be able to compete on the international market without need of protectionism. A problem with this is that not all industries develop to this level of competency while under protection. Canada's national policy of 1876 was an example of infant industry protection directed at improving Canadian manufacturing.

3: Learning by doing. This sort of goes along with infant industry protection, but along with protecting developing industries from international competitors, protectionism can also simply give those industries time to operate, which gives personnel time to gain mastery over certain procedures. In this way, countries can turn comparative disadvantages into comparative advantages.

PROBLEM! Not every industry which gets chosen for protection will ultimately grow up to be an international "winner", so each time the government placed an industry under protection, they are effectively gambling (as protectionism exacts economic costs) on their choice. If governments do this frequently, statistically, they are likely to choose more losers than winners, which would be quite costly.


4: Protectionism can allow certain key industries to earn economic profits and thus innovate more. As such, Canada has strategic trade policy in place with regards to Bombardier (if you remember, they're the company which made the olympic torches)


1: There are advantages from diversification. Countries which are only specialized in a narrow range of products may use protectionism in order to diversify their economies (which gives local firms a "safe space" to expand into new industries, thus increasing the range of products produced domestically). This can be useful in that it buffers the volatility and risk posed by price changes and new technologies by spreading production to several different sectors. The idea here is not to "put all of your eggs in one basket" (although, often, this is more of a political argument than an economic argument)

2: Protectionism lets governments protect favored groups! In Canada, competitive advantage favors skilled labour over unskilled labour, and as a result, free trade may lower the wages of unskilled laborers (who are now competing with wage slaves from overseas). Here, protectionism can redistribute income to certain productive groups, but at the expense of the collective standard of GDP. There is a deadweight loss!



1: "We've got to keep our money at home"
The Premise: If I buy a domestic good, by country will have both the good AND the money used to buy that good
Why it's incorrect: Domestic money is only useful for buying domestic goods. If you are buying foreign products, the money you spend on those products eventually gets used to buy Canadian products- it flows between the two trading countries

2: "We've got to protect ourselves from low-cost foreign labour"
The Premise: Low wage foreign goods will eliminate domestic goods from the market, and thus lower the domestic standard of living.
Why it's incorrect: This goes against the law of comparative advantage. Even if a foreign country can produce all goods at a lower cost than Canada, it would still be advantageous to trade, as trade will lower the opportunity cost of having certain products.

3: "Exports are good, and imports are bad"
The Premise: Exports add to domestic GDP, while imports take away from domestic GDP
Why it's incorrect: Standard of living is dependent on consumption, not production. If a country exports a lot of goods, but derives its comparative advantage by paying its workers very low salaries, then those workers will not be able to consume very many products, on average, and thus that country's standard of living will probably be quite low.

4: "Protectionism creates local jobs"
The Premise: Protecting the domestic market can help save local jobs, and thus combat unemployment
Why it's incorrect: Protectionism reduces employment in other sectors which may have local comparative advantages, and thus, while it may increase employment in one sector, the overall economic effect is inefficient.



TARIFFS: Import Duties- these are a tax on imports. They increase costs for domestic consumers, but benefit domestic producers (who can sell at higher than the world price) and the government (who receives tax revenue). Tariffs create a deadweight social loss for the economy as a whole.

Originally, at the world price, Canada will import 1500 units of this product, and domestic producers will supply the other 500 units needed to satisfy demand.

Once the tariff raises the prices, Canada only imports 500 units of the product, and domestic producers supply the other 1000 units needed to satisfy domestic demand (as you can see, demand has decreased due to the higher price).

Consumer lose surplus represented by sections C, D, E, & F due to the Tariff
Producers gain surplus represented by section C due to the Tariff (the increase in price times the increase in production, minus the costs incurred by increasing production)
The government gains section E due to the Tariff (the quantity of foreign imports at the Tariff price, multiplied by the amount of the Tariff)



An import quota is like a quantity ceiling- it restricts the quantity of products which a country will import
With a voluntary export restriction, the exporter agrees to limit the amount of exports it will send to any one country.
This incurs costs for domestic consumers, but benefits domestic producers
The net result is a deadweight social loss which is greater than that which results from a Tariff!

At the world price, Canada will import Q4 - Q1, and domestic producers will supply Q1
Let's say that a quota restricts domestic imports to Q3 - Q2. If this happens, then the domestic price must rise to P1, where the quota exactly satisfies the excess demand which domestic producers cannot meet.

Consumers lose surplus equal to E, F, G, H, & I due to the quota,
Producers gain surplus equal to E due to the quota
Since there is no taxation here, the higher price on the quota goods causes foreign producers to gain surplus equal to G & H


Usually, in trade barrier situations, exporters prefer a quota (so they can gain the extra revenue section) while importing governments prefer a tariff (so they can gain the extra revenue section).



1: Antidumping Duties
-Dumping is the practice of selling a good in a foreign country at a price below domestic prices at a reason other than costs
-This is like price discrimination (remember from micro) but on an international level
-Usually, it is only temporary, in order to sell off excess supply, or to weaken local industries and force reliance on foreign imports
-It is seen as anti-competitive, and many people believe that it is an unfair form of competition
-Antidumping duties (taxes to bring "dumped" imports back up to the domestic price level) are often used to compensate for this
-Recently, however, these have been abused and used as a non-trade barrier
-When Antidumping Duties are used, the domestic price becomes the price floor, regardless of the foreign price (which can lead to an inflexibility in domestic prices compared to the world price)
-As such, if the world price falls below the average costs for domestic producers, they are protected
-Often, the system requires foreign accusers to prove that dumping is occurring in order for antidumping duties to be instated

2: Countervailing duties: a tariff imposed as a trade remedy to counteract foreign governments subsidizing their industries
-Governments wishing to impose countervailing duties must prove that there is a foreign subsidy being used to bolster a certain foreign industry, and that it is significantly harming the prospects of domestic producers
-The U.S. is currently placing countervailing duties on Canadian softwood lumber.



GATT- The general agreement on trades and tariffs: an effort to reduce international protectionism

The Uruguay Round- reduced tariffs by 40%, but failed to deal with European and Canadian agricultural subsidies (eventually, they ended quotas, but replaced them with Tariffs in a process called Tariffication)

WTO- World trade organization- it has 148 members, it is a global organization which deals with the rules of trade, and it endeavors to lower trade and non-trade barriers. It also includes a formal dispute settlement mechanism

Doha Round- tried to reduce agricultural subsidies

The Battle for Seattle- People protested that human, labour, and environmental rights were not being addressed by the WTO. Interestingly, 3rd world countries often argue against considering these in trade deals

MAI- Multilateral agreement on investment: similar to WTO, but for investments

Free trade Area- Goods and services may move freely among member countries, but each member nation still sets barriers against foreign imports on an individual basis (like NAFTA) PROBLEM: Certain Tariffs have grandfather clauses, and thus persist despite agreements.

Customs Union- A free trade area, but with a common set of barriers against foreign imports (like Mercosur: Brazil, Uruguay, Paraguay, and Argentina)

Common Market- A customs union in which factors of production (i.e., workers) may move freely among member nations (like the EU)


Saturday, April 17, 2010

Gains from International Trade

OKAY! Let's talk turkey about international trade.

Over time, while world GDP had been increasing at a fairly constant rate, world trade has increased exponentially!

Canada is, itself, involved in quite a bit of international trade (we export and import quite a lot of goods)

David Rciardo was an economist of lore (1772-1823), and he was a major proponent of international trade. He wrote "Current comparative advantage is a major determinant of trade under free-market conditions."

Economists who advocated world trade often promoted teachings which led to real changes, such as England repealing its corn laws and moving towards a more open economy (an open economy is one which engages in international free trade, and realizes certain advantages from this, known as the gains from trade).

GAINS FROM TRADE: These are increases in total economic output due to efficiency advantages resulting from local economies engaging in specialization and trade of goods in which they have a comparative advantage.

COMPARATIVE ADVANTAGE: A situation where one local economy can produce a certain good at a lower opportunity cost than other economies (i.e., if it is less expensive for Canada to grow wheat than it is for Haiti to grow wheat, then we would state that Canada has a comparative advantage in wheat)

WHAT IS THE LOGIC BEHIND INTERNATIONAL TRADE? It's the same logic which states that interpersonal trade will be beneficial!
-When there is no trade on an interpersonal level, each individual has to be self-sufficient: they must provide for all of their own needs
-Trade allows individuals to specialize in providing goods and services which they can produce or provide efficiently, and then trade those for goods and services which they are less proficient at providing.

For an example, if I am a Doctor, I could be very very good at fixing coronary blockages, but terrible at fixing pipes. Trade means that I can simply make money by acting as a doctor, and then trade this money to "borrow" a trained plumber, thus saving me hours of frustration and reading complicated instructions. In this situation, both me and the plumber are providing the services which we are most efficient in, and because I don't have to waste time learning how to fix pipe and he doesn't have to waste time memorizing human anatomy, the overall economic output between the two of us is higher! We are more efficient when we can divide and conquer! =D

Well... interregional and international trade follows the same logic!

There are two different sources of gains from international trade:

1- The fact that different local economies have different resource endowments (and therefore can benefit from specializing in producing products which fit well with regional endowments, both natural and acquired)

2- The fact that international trade leads to a larger market for products means that local firms can realize reductions in production costs due to increased production (they are able to achieve economies of scale)


ABSOLUTE ADVANTAGE: This is when one country (or economy), compared to another, can produce more of a good from the same inputs

So, lets say that given the same inputs...

Canada can produce 10 bushels of wheat or 6 lengths of cloth
England can produce 5 bushels of wheat or 10 lengths of cloth

Canada has an absolute advantage over England in terms of wheat, and England has an absolute advantage of Canada in terms of cloth. Here, we have a situation of reciprocal advantage (each country is more adept at producing a different good), and thus it will be advantageous for England and Canada to trade!


Because each unit of input which Canada switched from cloth production to wheat production leads to 6 fewer cloths, but 10 more wheat. Similarly, each unit of input which England switched from wheat production to cloth production leads to 5 fewer wheat and 10 more cloth. The net effect of this is that the world production of both wheat and cloth has increased if both the countries specialize in what they are best at producing: there are worldwide gains from specialization.

But English and Canadian consumers want to purchase both goods... so unless these countries are able to trade, this specialization would not be practical.



Lets say that using one unit of input...

Canada can produce 100 bushels of wheat or 60 lengths of cloth
England can produce 5 units of wheat or 10 length of cloth

Here, Canada has can absolute advantage in both wheat and cloth (so Canada is more efficient at producing either of these products). Some people might think that Canada should thus not engage in trade... but they would be WRONG! Dead WRONG!

Canada can produce 20 times as much wheat at England, but only 6 times as much cloth using one unit of input. From this, we can surmise that Canada has a COMPARATIVE ADVANTAGE in wheat, while England has a comparative advantage in cloth.

Each country should trade goods in which it has a comparative advantage. Trade, in this case, increases the world's per-capita GDP. Comparative advantage is a necessary and sufficient condition for trade. Absolute advantages (in the absence of comparative advantages) do no lead to gains from trade.

How do we figure out which product a country has a comparative advantage in?

Easy! You just calculate the opportunity cost of producing any one good. Given the previous example, the OC of producing 100 bushels of wheat in Canada is 60 lengths of cloth, so the opportunity cost of each bushel of wheat is 0.6 lengths of cloth. Similarly, the OC of producing is length of cloth is 1.67 bushels of wheat for Canada. The opportunity cost for England of producing 1 length of cloth is 0.50 bushels of wheat, and the opportunity cost for England of producing 1 bushel of wheat is 2 lengths of cloth!

The opportunity cost of wheat is lower in Canada than in England, so Canada has a comparative advantage in wheat
The opportunity cost of cloth is lower in England than in Canada, so England has a comparative advantage in cloth

The point: opportunity cost depends on relative costs, no absolute costs!


*to note: increased production does not necessarily lead to increased consumption, and standard of living depends on consumption rather than production (so a country could produce a whole lot of products, but if its workers make very low factor incomes, and are hence unable to consume many goods, that country's standard of living may still be extremely low.)


If Canada can produce 100 wheats or 60 cloths given one unit of input
and England can produce 10 wheats or 6 cloths given one unit of input

Canada has the same absolute advantage of England in terms of both products, but each country has the same opportunity costs in terms of producing each good. Because of this, specialization and trade will NOT lead to any gains for either country, nor will it increase world output of either product.

There are other reasons in addition to comparative advantage that can make it beneficial to engage in specialization and trade

Basically, whenever OC's differ for the same products between different countries, specialization (and subsequent trade) leads to an increase in net production of goods, and as a result, a decrease in costs, because of...

1: Economies of Scale- Trade creates a larger market for domestic producers (who, after international trade, provide products for consumers around the world instead of just domestically)

2: Product Differentiation- A large international market for any type of product leads to further specialization, or product differentiation. For an example, in Europe, each country specializes in intra-industry trade. Between Canada and the U.S., each country specializes in a different type of car.

3: Learning by doing- Larger international markets lead to specialization, which leads to "accumulated experience". For an example, the silicon valley area of the United States has gained a reputation for computerized innovation, and as a result of that specialization, people from that area gain experience over time, and become better-equiped to compete in that industry.

Economies of Scale = Production moves to the bottom of the LRAC
Learning by Doing = The entire LRAC shifts downward, so any level of production costs less



1: Natural Factor Endowments
-This is how traditional economists explained comparative advantages
-What each country is "born with"
-This includes both natural resources and climates, as well as social patterns and institutional set-ups
-This natural resource advantage translates into cost advantages (i.e., a very fertile country will not incur as many costs growing food as an arid country)

2: Acquired Comparative Advantages
-This is a newer idea: what each country DEVELOPS can lead to a comparative advantage in certain products
-For an example, social fixtures such as education, healthcare, and social services can create more productive workers
-Research and development can also lead to innovations and localized experience which gives certain nations comparative advantages in certain sectors (like Canada and aerospace engineering, or Korea and shipbuilding)



We know that countries should specialize and then trade in goods in which they have a comparative advantage.

So... do countries actually export those goods in which they have a comparative advantage? The answer is YESSSSSSS!

THE LAW OF ONE WORLD PRICE: Internationally traded goods sell at the same price, regardless of which country they are sold in, assuming
-zero transport costs
-it is actually the same good
-competitive markets
-the good is tradable

World price simply equates global supply and demand for any product to determine the equilibrium price


If one country has a comparative advantage in a certain product which would potentially lead to a lower domestic price for this product than the world price level, instead of simply selling the product at the domestic price level, that country will sell that product on the world market at the (higher) world price level: the domestic excess supply will get sold off on the international market.

THE THEORY OF COMPARATIVE ADVANTAGE IS STILL RELEVANT~!! Sources of those competitive advantages may have changed over the years, but the basic premise of this theory still holds true!


TERMS OF TRADE: These determine how the gains from trade are shared- in other words, how will the gains in world per-capita GDP be shared among the trading nations.

The Terms of Trade = the ratio of (the price of exports / the price of imports)
The relative international price of imports (how many imports can be purchased per unit of export)

If the terms of trade increase, this is favorable for the nation in question, because they are able to get more imports per export. The reverse is true if the terms of trade decrease.

Unfavorable terms of trade will not be conducive to trade! Basically, if the terms of trade make it so that the OC of obtaining imports is equal to or greater than the OC of producing a product domestically, the country in question will not trade for that product! There needs to be a win-win situation (terms of trade which allow for both countries to enjoy lowered OCs) in order to trade to occur.


International Trade and the PPC:

When there is trade, consumption can differ from production! This means that trade can facilitate changes in production which allow for patterns of consumption which lie outside the PPC!

The slope of the dotted line = the terms of trade (tt)

Basically, given any point on the original PPC, international trade allows that country to trade products with another country at a rate which differs from that given on the PPC (which is usually convex). As you can see, if the country in the diagram specializes and trades, it can reach point B!

By specializing (changing production), countries can optimize their production in order to best take advantage of good terms of trade!

NOTE: Which country wins depends on the terms of trade (the slope of the line). Also, the consumption pattern (the point on the CPC) which each country settles into will depend on their preferences between the two products being compared.
Also, most countries have increasing OCs with increased specialization, and thus they have convex PPCs

That's all for now!

Wednesday, April 14, 2010


Okay- I'm really behind in these online notes, but I'm going to catch up as much as I possibly can tonight.

Unemployment is scary stuff! Here we go!

-In the long run, increases in the labor force should be matched by changes in employment (so as the population grows, more people should get hired for more jobs)
-In the short run, changes in the labor force may not match population growth

In Canada, the supply of labour has increased because of increases in the population (probably due to immigration), an increased rate of labor force participation, and an increase in education. Demand for labor has also increased due to new technology and economic growth. In most years, new jobs are created to replace old jobs and provide new jobs for the growing labor force.

In a typical year in Canada, employment increases by 1/4 million jobs.


-In Canada U was 12% in 1980, and 8% in 2008
-During booms, unemployment falls, and during recessions, unemployment rises. Doh
-In Canada, employment is rising, BUT the labor force is growing at a FASTER RATE, so in Canada, the unemployment rate has increased
-The proportion of employment in the service sector has increased (it is now about 75%)
-The proportion of employment in the goods sector has decreased

-According to Naomi Klein, North America produces "brands, no products"
-A lot of labour is outsourced these days
-There is a rise in the amount of low-skill service labor these days (i.e., McJobs)
-There is greater transience in the workforce: people move from job to job more
-Schedules are crappier, and employees receive fewer benefits
-There is less company loyalty, so quality suffers (the Wal-mart greeter makes about $11,000 working full time, so you can bet your ass she's not really that happy to see you)
-The best way to operate here is to see yourself as a movable asset: "Me Inc." sell yourself and you will be happy- attach yourself to any one company and you will not be happy

What are some reasons for these negative changes?
-Low ability levels
-The entry level for better jobs has significantly increased
-Flexible hours are now the norm
-Part-time workers have less legal protection (and are thus preferred)

-The labor market can be seen in terms of flows in about of unemployment, rather than as a simple unemployment rate
-We should examine gross rather than net flows (because this gives us more information about the nature of the labor market)

-Voluntary vs. Involuntary: Technically, voluntary unemployment does not exist, as that individual has technically left the workforce.
-Not all unemployment is bad!

Unemployment: All individuals who are willing and able to work at the going rate, but are unable to find a job

When there is a great deal of involuntary unemployment, we end up with something like the great depression:
-On a small scale, this causes personal hardship and psychological suffering for those who lose their jobs
-On a large scale, this decreases national output per capita, and by association, the standard of living- there is a loss in potential output


Why does it happen? It happens because there is a recessionary gap! (doh)

If Y = Y*, U =0
If Y < Y*, U > U*

Cyclical Unemployment is unemployment in exess of frictional and structural unemployment!

We could see the labour market as any other market where there is supply and demand for labour at different prices.
Demand = the willingness of firms to hire at any given wage rate
Supply = willingness of workers to work at any given wage rate
The price of labor is the real wage rate (w)

As the graph should demonstrate, labor markets are pretty flexible, because wages can shift upward and downward. With wage flexibility, real wages and employment change with economic cycles.

This graph shows that eventually, employment reaches an equilibrium! In other words, there should be no involuntary or cyclical unemployment in the long run...

There are two theories which examine gap unemployment


-We assume here that markets are flexible and that they will eventually clear
-This theory predicts that there will be no cyclical unemployment (but they're wrong! There is cyclical unemployment!)

Here's the logic: since wages are flexible, the labor market will always reach an equilibrium where the amount of labour supplied equals the labor demanded at the going wage rate. Here, no one is involuntarily unemployed, and thus, there is no cyclical unemployment. There are only people who are voluntarily unemployed (i.e., frictional and structural unemployment)

NAIRU, here, can occur due to

Exogenous demand shocks
-Changes in technology or tastes
-Changes in the demand for labour

Exogenous supply shocks
-Changes in the willingness to work
-Changes in the supply of labour

In this model, it is the NAIRU which fluctuates, since the unemployment rate is alwats the NAIRU

NOTE* Real wages ARE flexible and markets DO eventually clear, so this model isn't entirely wrong...

But there are PROBLEMS:
-According to this theory, real wages should change rapidly with the business cycle. This does not happen. Real wages remain relatively constant even as the economy fluctuates
-An unemployed person would be shocked to learn that economists veiw him or her as "voluntarily" unemployed
-This model seems to show that there is no need for stabilization policy, but in reality, we know that there IS!

thankfully, we have...

NEO-KEYNESIAN LABOUR MARKETS (aka, how they actually work)
-Here, labour markets are inflexible and do not clear... at least not in the short run
-This is because of STICKY WAGES! The wage rate does not change fast enough to equate the supply and demand of labour (because wages are not perfectly flexible), as a result, we get unemployment in slumps, and labour shortages in booms.
-Only when the supply and demand of labour are equal is there no involuntary unemployment: it is here that the market clears!

-Demand for labor decreases
-Wages want to fall to their new equilibrium level
-But wages stick at a higher level than the equilibrium
-So there is excess supply of labour, and thus unemployment

-Demand for labor increases
-Wages want to rise to a new equilibrium level
-But wages will not immediately increase to that new equilibrium level: it takes time for that to happen
-In the meantime, there will be excess demand, and therefore a labor shortage

We know that wages are much more likely to be "sticky downward" (they take longer to fall than to rise). Why is this?

-Long-term employment contracts: workers and employers respond to other factors like job security by creating long term contracts: here, wages are planned over the long-term and are thus insulated from short term fluctuations. The fringe benefits of these contractual agreements can be mutually beneficial, as they give employees long term stability, and ensure employers that they will have trained employees invested in the company over a longer period of time

-Menu costs: Changing wages in any way invokes administrative costs

-Efficiency wages: this is when employers pay employees higher wages than the equilibrium wage necessary to hire them, because they believe that the higher wages will act as a motivator, and cause workers to become more efficient

-Unions: unions negotiate on behalf of workers who are already embedded in the workforce, and thus often make it difficult to negotiate for higher wages

-Psychological factors: people find it psychologically difficult to give up wages (even if the price level is dropping, so real wages are effectively still the same)


In summary, Neo-Keynesians assume that markets may not clear, and thus there CAN be involuntary unemployment


In the short run, the Neo-Keynesian are correct: sticky wages can create excess supply or demand of labour... HOWEVER, all of the factors which contribute to sticky wages will not persist in the long run, so eventually, the labour market DOES clear, and wage flexibility eliminates involuntary unemployment. Thus, in the long run, both Classical and Keynesian theories predict that unemployment will be at U*

(The only differences is that for classical economists, there is no short run- that time frame is not taken into account)


-Wages are flexible, so the labour market will always clear
-U is always at U* and there is no gap unemployment (no involuntary unemployment)
-Aggregate demand shocks will have no effect on unemployment, because aggregate supply reacts

-Wages are sticky, and markets will not clear immediately
-U is not always at U*, so there can be gap unemployment (involuntary unemployment)
-Aggregate supply and demand shocks cause gaps


The Non-Accelerating-Inflationary-Rate of Unemployment (NAIRU)

There are 2 components to NAIRU: Frictional and Structural Unemployment

FRICTIONAL UNEMPLOYMENT (Job turnover, or search unemployment)
-This refers to the length of time it takes someone to either find their first job or a new job

STRUCTURAL UNEMPLOYMENT (Mismatching of supply and demand of labour)
-It can be supply-side (ie: a worker's skills are needed in an economy, but in a different city, persay)
-It can be demand-side (ie: there are jobs available, but they require more training than the current workforce has accumulated)

-Structural Unemployment may just be long run frictional unemployment
-Both are similar in that the number of unfilled jobs is equal to the number of people looking for work

NAIRU = The Non-Accelerating-Inflationary-Rate of Unemployment
-This is the rate on unemployment when inflation does not accelerate
-In other words, this is the normal, or natural rate of unemployment
-Here, we only have frictional and structural unemployment
-There is no cyclical unemployment at U*
-But "there is always some unemployment at full employment"
-This is the rate of unemployment when the supply and demand of labour are equal
-This is the rate of unemployment at Y*, or Yfe

NEWSFLASH: NAIRU can change over time! How does this happen???

1: Demographic Changes
-Baby boomers and shadow baby boomers, for example, entered the labour market and created a larger flow of voluntary unemployment, thus increasing NAIRU
-Historically, increased female participation in the workforce (where females historically have had a higher unemployment rate than men) will increase NAIRU
-Immigration may affect this as well

2: Labour Market Flexibility
-The speed at which wages adjust to supply and demand changes is slowing down over time
-It is more costly for firms to hire new workers these days, and due to unions and legal issues, it often takes them a longer amount of time to commit to hiring or laying off workers
-Unions and the psychology of concessions also play a role here

3: Government Policy
-Any government policy that reduces labour market flexibility will increase the NAIRU
-EI decreases search costs (the opportunity cost of searching for a new job) and will therefore increase average job search times, thus contributing more to NAIRU
-Severance Pay increases the cost of firing a worker, but at the same time, also makes companies less willing to hire new workers in the first place (its a higher risk, so firms must be more discerning)

4: Globalization and Technological Changes
-Rightsizing, restructuring, retooling, and rationalizing, global competition, and freer trade have increased structural unemployment, many would argue (mature industrial nations such as Canada are expected to provide high level services and technology, while countries with cheaper labour are expected to provide lower level manufacturing and production, but this can often lead to a mismatch between available worker skills and desired potential employee assets)

5: Hysteresis (A lagged effect)
-This theory suggests that the future NAIRU is a function of the current actual rate of unemployment
-This is seen more in European countries with an insider-outsider model to the workforce: in these countries, people who are already employed use their insider power to keep outsiders out
-Recessions prevent on-the-job training and thus reduce the amount of "learning by doing" which can occur, and as a result, when a recession is over, the group of people who would otherwise have gained skills due to simply being employed are left without employable skills, and may thus continue to struggle to find employment


OKUN's LAW!!!!!!!!!!!!!!!!!!!!!!!!!!

A 1% Change in the cyclical unemployment rate is associated with a 2% change in the recessionary gap!

So... if the economy goes into a recession and is producing output at 12% below its potential level, than we know that cyclical unemployment has risen by 6%. Similarly, if cyclical unemployment were in increase by 3%, we could predict that output would decrease to 6% below Y*

HOW TO ESTIMATE NAIRU: You need to know Y*, the current output level, and the actual unemployment rate

1: Find Y* (potential output level)
2: Calculate the recessionary gap as a percentage of Y*: (Y-Y*)/Y* multiplied by 100
3: Take 1/2 of the recessionary gap you just calculated. This is the cyclical unemployment rate
4: Subtract the cyclical unemployment rate from the actual unemployment rate. The difference is the normal U-rate, or NAIRU!




Reducing Frictional Unemployment:
-Here, the goal is to decrease turnover time
-Governments could create giant posting boards to match potential employers with potential workers (i.e., Canada Manpower, workopolis, craigslist)

Reducing Structural Unemployment
-The goal here is to make the supply and demand of labour match
-Government initiatives to retrain and relocate workers can help here
-Eliminating resistance to change (i.e., tariffs and subsidies) can help, as these instruments perpetuate the status quo, and may deter people from getting the skills needed to operate in the new global labor market (i.e., if a tariff is supporting a failing industry, then that tariff is also going to deter people employed in that industry from getting the retraining they require to become employed once that industry inevitably topples)
-Aiding change is key here

Reducing Cyclical Unemployment
-The goal here is to bring Y back to Y* by increasing aggregate demand
-This accomplished using fiscal and monetary policy
-YAY! Gap-busting! =D =D

That's all for unemployment. I hope all of you who read this are successful at avoiding summer employment....

Saturday, March 27, 2010

More Irritating Details About Inflation

The Phillips Curve & Accelerating Inflation

-We know what the Phillips curve is. I'm not explaining it again.
-At Y* and U*, there is no gap inflation
-When the economy is in an inflationary gap, the BoC must validate for wage inflation
-In the 1960s, the level of wage and price adjustment began to rise for any level of output (the whole phillips curve shifted to the right)
-Why? Because the original phillips curve included only gap inflation and ignored expectation inflation (which impacts wage changes, obviously)
-This newly-shifted phillips curve is called the expectations-augmented phillips curve. There is still an inverse relation between the unemployment rate and the rate of changes of nominal wages, but with the effect of expectation inflation built into the model.
-Expectation inflation is graphically represented by the height of the phillips curve above the X axis at U*

Using this new phillips curve, we can see than when there is gap inflation, and when there are expectations adding to inflation, the curve shifts up at Y*: expected inflation increases for all levels of inflation, and thus, inflation can accelerate.



Is inflation a monetary phenomenon? Was Milton Friedman correct when he said "Inflation is everywhere, and always a monetary problem"?

Does inflation have purely monetary consequences? What about its consequences- are they purely monetary?

Well... inflation on its own can be caused by either an increase in AD or a decrease in A. However, unless monetary validation is continuous, inflation will only be temporary. As such inflation is not necessarily caused by monetary issues, but continuous inflation IS.

The consequences of inflation:
1: Short run gap inflation caused by output being higher than Y*
2: Short run supply inflation caused by Y being less than Y*
3: In the long run, output will always eventually return to Y*, so inflation will only cause a change in the price level.

so... SUSTAINED inflation is everywhere, and is always a monetary problem.


REDUCING INFLATION: The process of disinflation

Accelerating Inflation is inflation. There is a positive change in the price level.
Constant Inflation is inflation. There is a positive change in the price level.
Decelerating Inflation is disinflation. There is a positive change in the price level, but at a decreasing rate.
Stopped Inflation is zero inflation. There is no change in the price level.
Reverse Inflation is deflation. There is a negative change in the price level.

How do we reduce constant inflation from occurring at Y*??? by STOPPING EXPECTATIONS
How do we reduce accelerating inflation? By NO LONGER VALIDATING CHANGES IN THE ECONOMY

both of these measures may cause short-term economic pain (recessionary gaps cause unemployment, which is both depressing for individuals, and unproductive for economies in general). However, this will eliminate sustained accelerating inflation.

But is this a good thing?

There is often questions over whether the benefits of reducing inflation outweigh the costs.

How it works:
1: remove monetary validation to eliminate the inflationary gap (which allow the SRAS to return GDP to Y*)
2: stagflation: the SRAS decreases to the point where it actually overshoots Y* due to the intensity of wage momentum. As a result, there will be a period of rising unemployment accompanied by inflation
3: recovery: wage adjustments can bring SRAS back to Y* the slow way, or the BoC can use expansionary monetary policy to bring it there faster (at the cost in inflation)

The cost of disinflation:
-Disinflation is caused by a recessionary gap
-The cost of disinflation is equal to the loss of output caused by the required recessionary gap.

The SACRIFICE RATIO is the cumulative loss of output as a percentage of potential output divided by the percentage reduction in the inflation rate.


THE COSTS OF INFLATION: Why is this bad, again?

1: Unanticipated Inflation
-Affected the distribution of income (redistributes income from creditors to debtors)
-Wage contracts: redistributes income from employers to employees if inflation is less than expected, and vice versa if inflation is higher than expected
-Pension contracts: redistributes income away from pensioners (although this can be solved by indexing pensions for inflation)

1970s: Trudeau indexed public pensions, and they have remained indexed as thus until..
1980s: Mulroney de-indexed tax brackets
2000: Chretian fully indexed tax brackets

Low versus Moderate Inflation: BC advocates low inflation
-The price signal distortion hypothesis suggests that inflation interferes with the information conveyed by price changes. As a result, market participants can have a difficult time distinguishing absolute prices from relative prices. This extra confusions created by inflation reduces market efficiency
-In PLANNING DISRUPTION, inflation interferes with retirement plans and long term contracts

With moderate inflation...
-The downward nominal wage rigidity hypothesis claims that low levels if inflation reduce economic efficiency, because real wage cuts will require nominal wage cuts, which will be resisted. Basically, if inflation is zero, a 2% cut in real wages required a 2% cut in nominal wages: workers will resist a drop in their nominal wages. However, if inflation were high enough, nominal wages could simply be maintained to the effect of reducing real wages, and this is met with much less resistance. In this way, this theory suggests that high inflation facilitates more efficient economies, because it makes it easier for employers to "trick" their employees into accepting real wage cuts.

The zero bound on nominal interest rates hypothesis claims that the BoC cannot run expansionary money policy.

AS A GENERAL RULE, healthy economies have moderate inflation (this is caused naturally by economic growth and increases in aggregate demand).

High and accelerating inflation leads to prediction problems, and arbitrary redistribution of income. It may also lead to hyperinflation. Politics, however, is usually the entity to blame for these problems.

HYPERINFLATION: This is associated with low economic growth. Why? Because hyperinflation increases transaction costs (ie: menus must be changed constantly, and holding money for transactions is risky, because that money's purchasing power can rapidly decrease)

DISINFLATION: Governments can try to use wage or price controls, but usually this doesn't work.
-Two recessions in Canada have been caused by the government of Canada attempting to slow the rate of disinflation. As such, the costs of disinflation probably outweigh the benefits unless inflation is getting seriously out of control.

DEFLATION: Like disinflation, is not a good idea.


Demand Shocks and Accelerating Inflation

-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(


-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.
-When AD and AS both shift up, the inflationary gap will persist.
-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.

SO... two questions we need to answer are:

1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?

The answer: Validation


2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?

The answer: Expectations

-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...
-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...
-THEN, inflation will persist, and be accelerating.

In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).


1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)
-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism
-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).
-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.
-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year
-This continues on for quite a while, generating an inflationary spiral.

AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.

-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.
-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)
-This validation becomes more and more dramatic as time goes on

Let's summarize what we know!

We have an isolated shock ---> There will be no gap in the long run
We have have a repeated AS shock ---> There will be a persistent gap
We have a repeated AD shock ---> There will be a persistent gap

At Y*, persistent inflation will consist of only expectation inflation
With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation

Cost push inflation from Y* lead to a recessionary gap
Demand pull inflation from Y* leads to an inflationary gap

AGAIN: Is monetary validation a good idea?
Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"
No, because it causes inflation

Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!

Inflation and Supply Shocks

-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary
-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises

Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).


3: SUPPLY SHCOK INFLATION (even though that's a bit of an afterthought)

Next, we're going to talk about the difference between sustained/constant inflation and accelerating inflation.

-Here, we assume that there is no supply shock, and no output gaps
-As such, the ONLY cause for inflation when there is sustained inflation, is expectations
-This kind of inflation occurs when Y is equal to Y*

Let's summarize: constant inflation occurs when...
-There is no gap inflation
-There is no supply shock inflation
-Monetary growth is equal to the rate that wages increase at
-Actual inflation is equal to expected inflation

1: Worker expectations trigger constant inflation (expectations cause workers to demand higher wages, which then causes SRAS to shift to the left)
2: The BoC validates the price increase by increase the money supply

SO.... let's say that we start off with expectation inflation at 2%. Workers anticipate future increases of 2% in the price level, so they demand higher wages, which causes SRAS to shift to the left as money wages rise. When the government validates this increase, they increase the money supply, which shifts SRAD to the right. Because of the way that this mechanism works, the price level will rise at the exact same rate as is predicted (because expectations are what catalyze the change). Actual inflation is equal to expected inflation, and output remains at Y*. THIS IS CONTINUOUS INFLATION AT A CONSTANT RATE.

NOTE* This isn't expansionary monetary policy- the BoC is not reducing the overnight target rate here- interest rates aren't affect by this. The BoC is merely accommodating for the growing demand for money by steadily increasing the nominal money supply. As such, the real money supply remains constant (so the ratio of money in the economy and the average price of products remains the same).

INFLATIONARY SUPPLY SHOCKS (negative supply shocks which temporarily inflate prices)
-Remember, in all cases of inflation, the price level rises to a new equilibrium level. In temporary inflationary situations, the price will simply remain at the new level, whereas in cases of persistent inflation, the equilibrium price level will continue to rise.

Inflationary supply shocks are caused by increased cost of productive inputs (for an example, an increase in the price of oil). This, in turn, causes costs to rise, which shifts SRAS to the left, and increases the price level while decreasing output.

BUT... as we know from previous chapters, this change is NOT permanent. Eventually, the higher unemployment which accompanies the supply-shock-recession puts downward pressures on wages, eventually causing them to fall. As a result of these wage-related cost savings to firms, the short run aggregate supply will shift back to its original level: costs will be the same as they once were, even though workers are being paid less. As SRAS shifts to the right, the price level and output level both shift back to what they were originally. SO, WE CAN CONCLUDE THAT INFLATIONARY SUPPLY SHOCKS ONLY CAUSE INFLATION IN THE SHORT RUN, AND THAT THERE IS NO SUSTAINED INFLATION HERE.

Well, we start out at macroeconomic equilibrium, and then we shift SRAS to the left. This increases the price level and decreases the output level. After this, if the government tries to correct this recessionary gap by increasing the money supply (the money supply increases, which lowers interest rates, which increases investment and net exports, which drives aggregate expenditure up and shifts aggregate demand to the right), aggregate demand will shift to the right, which will bring output back to its equilibrium level, but at a higher general price level. As such, there will be more inflation than if the government does not intervene, but prices will still settle at the new equilibrium level, and inflation will not be persistant.

For an example, lets say we have cost push inflation, which occurs due to repeated increases in firms' costs. What happens then? Well, either the economy will stabilize at a higher price level and a smaller output level, OR persistent unemployment will erode the power of unions, causing monetary wages to fall, and bringing short run aggregate supply back to its original levels.

Well, then economies can enter into an inflationary spiral. For an example, if unions consistently negotiate to increase their monetary wages, and the government consistently validates this decrease in SRAS by printing more money, then an economy will experience consistent inflation (albeit, often the wage increases are very small, so inflation persists at a small but constant level). Basically, monetary validation reinforces price increases and offsets the natural tendency of Ye to return to Y* on its own, hence sustained inflation.

So.... is monetary validation of supply shocks desirable or undesirable? Yes and No!

No, because the BoC should allow for unemployment, which will eventually eliminate the output gap through the natural chain and anchor process.
Yes, because nations can avoid severe (albeit temporary) recessions by using monetary validation (although this comes at the cost of creating higher prices)

So its sort of a dilemma: governments must choose between long stretches of unemployment (no validating) or inflation (validating).

What is STAGFLATION? Stagflation is when supply shocks and monetary validating occur simultaneously, which leads to a NEGATIVE COMBINATION OF INFLATION AND UNEMPLOYMENT

Persistent Recessionary Gaps + Persistent Inflation: Continous SRAS shocks continue to push SRAS to the left, while continuous validation continues to push AD to the right. The overall effect on the output level is neutral, so the original recessionary gap is never closed. At the same time, both supply shocks and monetary validation continuously push up the price level, so the equilibrium price level will continuously rise while the economy remains in a recession. =(

The Gap Effect, and the Expectation Effect


People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.

On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)

Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)

Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%

Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)


One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.

We're going to look at why NAIRU is called NAIRU in this chapter



Okay... why do people's wages change?

There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect

-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).

The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.

Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).

Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...

They were entirely correct... there is also...

-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!

Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.

The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.

Wednesday, March 17, 2010

Monetary Policy in Canada

This is the last piece of the puzzle! This chapter is all about how the government of Canada uses policy instruments to change the money supply!

The central bank can set the money supply and let the market determine the interest rate


The central bank can set the interest rate and the money supply will adjust to this interest rate

-The Bank of Canada (BoC) cannot directly control the money supply through the currency ratio and the reserve ratio (they can't control minds and make banks hold more or less assets and make people hold more or less money)
-Also, it's sometimes confusing as to which definition of the money supply should be used: H? M1? M2? Know know...

SO, the BoC sets the interest rate instead, and then accommodates for fluctuations and changes by using open market operations. (The US directly changes the money supply by printing more or less money, while Canada simply changes the bank rate)

There are 5 Different Policy Instruments The BoC Uses:
1: The Overnight Target Rate (Which is changes by changing the Bank Rate)
2: Buyback Operations (Specials and Reverses)
3: Shifting Government of Canada Accounts
4: Moral Suasion
5: The Announcement Effect

NOTE** It's important to know the difference between operational targets: usually, governments can only target one factor, so they have to choose between targeting

a) The Exchange Rate (from 1962-1970, Canada targeted the exchange rate and tried to keep its external value at 92.5)
b) The Interest Rate/Money Supply (from 1975-1982, the BoC would adjust interest rates to affect the money supply through the liquidity preference system. The problem was that interest rates became extremely volatile, and the government had no way of controlling the price level)
c) The Inflation Rate (the BoC uses interest rates and money supply as a policy instrument to affect the inflation rate, so the operational target is currently PRICES. The BoC tries to keep inflation at about 2%, because a little bit of inflation is healthy

Policy Variables: These are the ultimate targets for policy changes
Y - stable economic growth
U - low unemployment




Note* the interest rates on borrowing increase as the term of the loan grows longer (as a compensation for leaving money inaccessible for a longer amount of time)

The Overnight Rate: This is the daily interest rate which chartered banks charge each other for borrowing money (or that investment dealers charge to banks for borrowing money) in cases where they have insufficient funds to clear cheques. These loans have a very short maturity (the term is extremely short) and the interest rates are MARKET DRIVEN


The Bank Rate is the rate which the BoC charges to lend to money to chartered banks. This is the upper limit of the overnight rate. Because the bank rate is so high, most chartered banks will not borrow from the bank of Canada unless all other sources refuse to loan them money

The Overnight Rate Operational Band: This is the difference between the highest overnight rate (the bank rate) and the lowest overnight rate (the rate the BoC pays to borrow for depoits)
-It is measured in basis points (each basis point is worth 0.01%, so an operational band of 50 basis points would mean a difference of 0.5% between the highest and lowest overnight rates)

Overnight Rate Target: the midpoint of the operational band for overnight rates, as set by the BoC
-THIS is the policy instrument used by the BoC to affect the interest rate
-There are fixed announcement dates: the BoC announces the overnight rate target 8 times per year

The USA uses a slightly different system...

OKAY: so basically, the bank rate is FIXED by the BoC
-Money's liquidity (the demand for money) is given
-The BoC accommodates the money supply to ensure equilibrium in the money market
-The money supply is thus endogenous, and becomes determined from the interest rates and the demand for money!

1: BoC increases the overnight rate (i goes up)
2: Banks increase their target reserves to buffer against this higher opportunity cost of borrowing from the BoC
3: The money supply decreases (because the reserve ratio is higher)
4: The market interest rate goes up!

This is a long-about way of showing how the market interest rate (which includes the prime rate, the 5-year mortgage rate, and commercial lines of credit) is related to the overnight interest rate!

NOTE* A change in the overnight rate target and other market interest rates usually happens very quickly BUT the demand for loans changes gradually (so the first step of the overall transmission mechanism is much faster than then subsequent steps)

As the demand for money changes, the BoC accommodates by using open market operations!

-The BoC Uses Specials and Reverses to stabilize the overnight rate inside the operational band
-Buyback operations are used to fine-tune the overnight rate target within one basis point of the target

SPECIALS (Specials purchase and resale agreement):
-This is a transaction in which the BoC offers to purchase government of Canada securities from major financial players with an agreement to sell them back at a predetermined price the next business day
-This allows the BoC to put money into the system for one day
-This OFFSETS UPWARD PRESSURES on the overnight rate (by adding a bit to the money supply, the BoC decreases the interest rate a little bit)
-The BoC initiates SPRAs daily if overnight funds are generally trading above the target rate
-Differences between the purchase and the sale price determines the overnight rate

REVERSES (Sale and repurchase agreement)
-This is a transaction in which the BoC offers to SELL government securities to major financial parties with an agreement to buy them back at predetermined prices the next business day (this sale is called a reverse)
-Basically, this let's the BoC take cash out of the system for a day (by coaxing investors to temporarily store wealth in bonds instead of money)
-Reverses are used to offset downward pressures on the overnight rate
-The BoC initiates reverses daily if overnight funds are generally trading below the target rate

-An OMO is the purchase/sale of government securities by the BoC in the open market for long run monetary accommodation
-Government securities are long run loans to the government
-Treasury bills are short term loans to the government
-These are auctioned off every Thursday, just like stocks, in a market

The BoC BUYS securities to increase excess reserves and attempt to increase the money supply
The BoC SELLS securities to decrease excess reserves and attempt to decrease the money supply

This analysis assumes that there are no cash drains, and that the reserve ratio remains constant in the long run (neither of which may be true)


Cash Management: The Bank of Canada shifts Government of Canada deposits to and from the Bank of Canada and the chartered banks. This is the major day-to-day instrument which the BoC uses to reinforce overnight rate targets within the operational band

Transferring money to a chartered bank increases their reserves, which allows the chartered bank to safely lend out more money, thus increasing the money supply
Transferring money from a chartered bank back to the BoC decreases chartered banks' reserves, which forces the chartered bank to lend out a smaller proportion of money, thus decreasing the money supply


-The BoC enlists the cooperation of commercial banks
-This is possible because there is such a small number of banks in Canada
-Since there are not required reserves in Canada (required reserves are not legislated), this tool is more important
-For an example, the BoC may require an increase in settlement balances held at the BoC


-There are fixed announcement dates where the BoC announces the bank rate (8 times per year)
-Like moral suasion, an increase in the bank rate sends a signal to the economy of the government's intentions, which can affect private investment (due to changed expectations)

CONCLUSION: The BoC fixes the overnight rate target, then uses buyback operations and shifting to reinforce it and open market operation to accommodate the demand for money in the long run

1: Policy instruments: The BoC sets the bank rate
2: The Money Market which defines reserves determines the money supply and the equilibrium interest rate
3: Transmission to real sector through the investment and net export effects


-Decrease the target rate
-Increase the money supply
-Decrease interest rates
-Increase Investment and net exports
-Increase Aggregate Demand
-Y moves to the right, back to Y*

-Increase the target rate
-Decrease the money supply
-Increase interest
-Decrease investment and net exports
-Decrease aggregate demand
-Y moves left to Y*

The Transmission Mechanism

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

There are two reasons why interest rates and desire for investment are negatively related
-lower interest rates mean that there is a lower opportunity cost for investing (it costs less to borrow money)
-when interest rates are lower, investing in capital becomes more attractive than keeping money in bonds (so if buying a new mixmaster will have a 4% yield, my friend the baker is much more likely to buy one when an equivalently-priced bond would only give him a 2% yield)
-Investment is determined by the REAL interest rate: for simplicity's sake, just assume that there is no inflation in this model for now

SO: There is an investment transmission mechanism

Let's do this in steps

1: The government changes the money supply (we'll learn how in the next little while)
2: The change in the money supply, thanks to the way the money market works, causes interest rates to fall (this is liquidity preference theory)
3: Lower interest rates cause investment to increase (this is marginal efficiency of investment theory)
4: Increased investment causes the family of aggregate expenditure curves for this economy to shift up
5: A shift up in aggregate expenditure causes aggregate demand to shift to the right, indicating an increasing in GDP, a decrease in unemployment, and an increase in the price level

BE SURE THAT YOU CAN REPRESENT EACH OF THESE STEPS GRAPHICALLY! If you have any questions about that, just send me an email and I will spell it out for you! =D



In open economies, consumers are not restricted to buying domestic bonds- they can also buy bonds sold by foreign governments. Thus, when the interest rate falls for one country in comparison with other countries, this makes that particular country's bonds less attractive for investors (if China's interest rate is 25% and Canada's is 4%, why the hell would you put your money in Canadian bonds [assuming the Chinese bonds were relative risk-free]). As a result, when domestic interest rates fall, investors tend to pull money OUT of the domestic economy and into foreign economies. This DEVALUES domestic currencies.

We know that when domestic currencies are devalued, this makes it more attractive for foreign economies to import domestic goods, and less attractive for local consumers to import foreign goods (for price-related reasons). Thus, net exports increases. This leads to an increase in aggregate expenditure, and subsequently, an rightward shift in the aggregate demand curve!

SO! There are 2 different pathways through which changes in the money supply can affect aggregate demand in an economy (and by association, Y, U, and P)



Classical economists divided the economy into real and monetary sectors: they believed that changes in the money supply only affected the price level, but would not impact GDP in the long run
MV = PY where V and Y are constant (money has a constant velocity, and GDP tends to return to its potential leve in the long run)

Modern economist now understand that in the short run, changes in the money supply CAN impact GDP through the monetary transmission mechanism. At the same time, they state that in the long run, the "anchor and chain" mechanism will bring GDP back to its potential level (through wage adjustment)

Pretend this graph indicated that the increase in AD was due to an increase in the money supply. In the long run, inflationary pressures cause wages to increase, which effectively raises costs for firms. This shifts aggregate supply to the left until the real GDP is back at Y*, but at a higher price level

Hysteresis: some economists debate that Y* can be affected by short run trends in Y, not just factors and productivity (for an example, a long-lasting recessionary gap may cause worker skills to depreciate, thus bringing productivity down, and consequently lowering potential GDP as well)


-Changes in the money supply cause larger changes in the interest rate when the money-demand curve is STEEP
-Changes in the interest rate cause larger changes in investment when the MEI curve is very FLAT

MONETARISTS: believe that the LPF is steep and the MEI is flat- they think that monetary changes can cause LARGE changes in GDP and price levels
KEYNESIANS: believe that the LPF is very flat and that the MEI is very steep- they think that monetary changes are much less effective than fiscal changes in affecting GDP and the price level

That's all for now. Only one more bit to cover for the midterm! =D

The Demand & Supply for Money

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)

-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest


-People hold money so that they can make transactions

-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"

-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)

The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)

The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)

Income, Prices, and The Nominal Interest Rate Affect Demand for Money!

The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation

The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation

The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation

Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)


-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services

(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier

Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)

Equilibrium occurs when demand and supply for money intersect: M = L

Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates

Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.

That's all for now!